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(a) Importance of inventory
•• Inventories are important to the financial statements because the inventory figure,
particularly for manufacturing companies, may be material to the balance sheet and
income statement, both in the current year and as a comparative figure.
•• Inventories may be high risk if they are valuable, and/or easily portable. The valuation of
inventories is a matter requiring the exercise of judgment, which means that inventories
are sometimes used to manipulate the appearance of both the income statement and
the balance sheet.
•• In the income statement, there is a direct relationship between the inventory figure and
the profit for the period. If closing inventories are overstated, profits will be overstated.
•• Many key accounting and performance ratios are calculated using the inventory figure.
These include inventory turnover, inventory days, the current ratio and working capital
ratios. Many companies use these ratios for internal purposes and many third parties,
such as investment analysts, also use these figures to assess performance.
•• Poor inventory control will be reflected in inventory figures at the period-end. For many
companies, excess inventory is a sign of serious problems.
•• Some significant cases of litigation against auditors have involved the alleged
overstatement of inventories in financial statements of companies where the auditors
have issued an unqualified audit report before the company has been taken over.
•• There is sometimes relatively little audit evidence for the inventory figure, particularly
for small companies and it is therefore important for auditors to scrutinize the evidence
available carefully and consider the scope for misstatement or deliberate manipulation
of the inventory figure.
(b) Cost and net realizable value
•• IAS 2 requires that cost comprises all costs of purchase, costs of conversion and other
costs incurred in bringing the inventories to their present location and condition.
•• Costs of purchase include the purchase price, import duties and other taxes, transport,
handling and other costs directly attributable to the acquisition of finished goods,
materials and services. Trade discounts, rebates and similar items are deducted.
•• Costs of conversion include costs directly related to units of production such as direct
labour. They also include a systematic allocation of fixed and variable production
overheads that are incurred in converting materials to finished goods.
•• Fixed production overheads are indirect costs of production that remain relatively constant
regardless of the volume of production such as depreciation, the maintenance of factory
buildings and equipment and the cost of factory management and administration. The
allocation of fixed overheads is based on a normal level of production.
•• Variable production overheads vary directly, or nearly directly, with the volume of
production and include indirect materials and labour. The allocation of variable overheads
is based on actual levels of production.
•• Other costs might include the costs of designing products for specific customers and
borrowing costs, which may be included in certain circumstances.
•• Costs not included are storage costs, unless these are necessary to the production
process prior to completion, general administrative overheads and selling costs.
•• Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale, such as advertising costs.
(c) Audit evidence
•• The costs of purchase for a furniture manufacturing company will include purchase
costs such as the cost of timber, metals, fabrics, fillings and adhesives.
•• These costs can be checked on a sample basis from the inventory records through to the daybooks, ledgers and purchase invoices, ensuring that the correct amounts have been recorded in the correct period.
•• The variable production overheads will include direct labour costs (including tax and
social insurance costs), the cost of power for factory machinery, the cost of small tools
and similar items that are directly related to the level of production.
•• Direct labour costs can be checked to payroll records, production records, timesheets
or clock cards, and payment records, including entries in the bank statements. It is likely
that the cost of power for machinery will have to be allocated, but if this is not possible
it may be necessary to include such costs in fixed overheads. In either case, the cost
can be traced to utility invoices and accruals. The costs of small tools can be checked
in the same way as purchase invoices, ensuring that capital items are not included in
the revenue accounts and vice versa.
•• Fixed production overheads will include depreciation of machinery, the cost of heat
and light in the factory, factory administration overheads and storage space for work
in progress. It is important to establish that the factory is operating at a normal level of
activity. If it is not, it is not appropriate to include overheads on the basis of an abnormal
level of activity.
•• Depreciation can be checked to asset registers. It is important that auditors examine
both the accuracy of calculations, and the reasonableness of the depreciation rates
applied as costs may be inappropriately included as assets, otherwise.
•• Factory administration may include the wages and salaries of those administering the
factory payroll for example, and the costs of the offices in which such staff work. It may
be necessary to split such costs out from general administration overheads that should
not be included. The attributable payroll and overhead costs can be checked in the
same way as for direct factory costs.
•• Analytical procedures can also be performed on all of the costs noted above and
compared with prior periods and budgets, as well as production levels, profits and
factory capacity where they vary directly with production or sales.
•• Analytical procedures on gross margins will also provide audit comfort on costs.
•• Cut-off tests may include checks between inventory records, the inventory itself, and
purchase and sales records for a period just before and just after the period-end. It
may also be necessary to examine provisions for goods dispatched or received but not
invoiced before the period-end.
•• The net realizable value of finished goods will only be relevant if it is likely to be lower
than cost, i.e. if furniture is to be sold at a loss. Auditors should review inventory counting
results and inventory records for old or slow-moving inventory and form an opinion, in
discussion with directors, as to whether any such inventories need to be reduced to net
realizable value.
•• Evidence from post year-end sales or contracts is a good source of evidence in relation
to net realisable value. If these are not available, it is important to review the entity’s
previous experience of having to sell furniture below cost. Current market conditions
are relevant as is the existence of a high level of inventories, which may indicate
problems.
Wilfykil answered the question on April 13, 2019 at 07:27
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